This article appears in the March 2016 ETFInvestor newsletter

Senior Loan ETFs:

Risks and Opportunities
Perspective | Alex Bryan

Bond investors should expect no free lunches. Higher

yields are almost always compensation for greater
risk, whether that risk is apparent or not. The potential
of rising interest rates is a meaningful risk that
could create a headwind for bond investors. Investors
could reduce their exposure to this risk by shifting
assets to short-duration bonds. But conventional shortterm bonds tend to offer lower yields than their
longer-duration counterparts. Substituting credit risk
for interest-rate risk is a potential solution that
may allow investors to earn higher returns. Senior
loans (also called bank loans and leveraged loans)
do just that.
A senior loan is a private loan that a firm takes out
from a bank or a syndicate of lenders. These loans
are backed by borrowers assets, which serve as
collateral. In the event of a default, the lenders have
a senior claim on the firms assets, meaning that
they get paid before other creditors. Thats good,
because almost all rated senior loan borrowers have
below-investment-grade credit ratings.
Senior loans are appealing to low-credit-quality
borrowers for a few reasons. First, this source
of financing allows them to borrow at lower interest
rates than they could in the bond or unsecured
bank-loan market. Borrowers can also customize
senior loans, repay them early with little or no
penalty, and keep sensitive information private. In fact,
borrowers have the right to reject the transfer of
a loan outside the original syndication group. Morecreditworthy borrowers tend to prefer unsecured
bank and bond market financing because it can be
costly to tie up assets in a loan. Senior loans may
also have more restrictive covenants.

Default rates on senior loans have historically been

slightly lower than those for high-yield bonds.
This is because its generally more difficult for these
borrowers to restructure their debt and experience
a technical default (that is, one not triggered by
a payment shortfall). From 1998 through 2015, the
average default rate on senior secured loans was
3. 2%, based on the S&P/LSTA Leveraged Loan Index.
The corresponding figure for high-yield bonds was
4.6%. Additionally, defaulted senior loans have higher
recovery rates because of their seniority in the capital
structure. From 1998 through 2015, the weighted
average recovery rate for senior loans was 80.1%,
while the recovery rate on high-yield bonds ranged
from 26.8% to 41.1%, according to data from S&P
Capital IQ LossStats & LCD reported by the Loan
Syndications and Trading Association. So while these
loans have considerable credit risk, senior loans
have tended to expose investors to smaller credit
losses than high-yield bonds.
Almost all senior loans have a floating interest rate,
which changes with market rates. They typically
pay a fixed spread above a benchmark rate, such as
Libor, often subject to a floor (for more information
on interest-rate floors, please see Why Yields on
Floating-Rate Bank Loans Arent FloatingYet
in the June 2015 issue of ETFInvestor). These rates
usually reset once per quarter, which gives senior
loans very a short duration and mitigates the impact
of fluctuating interest rates on their prices. This,
together with high recovery rates and borrowers
prepayment option, mitigate these loans deviations
from par value.
From December 1996 through January 2016, the S&P/
LSTA Leveraged Loan 100 Index exhibited about
two thirds the volatility of the Bank of America Merrill
Lynch U.S. High Yield Master II Index. However, the
leveraged loan index fared slightly worse from a risk/
reward perspective, as evidenced by its Sharpe ratio
in the accompanying table.

Morningstar ETFInvestor

Annualized Performance (12/199601/2016)

S&P/LSTA
Leveraged Loan

BofAML US HY
Master II TR USD

Return (%)

4.73

6.35

Std Dev (%)

6.00

9.18

Sharpe Ratio

0.42

0.45

Risk Free Return (%)

2.23

*Note: The risk-free rate is based on the one-month T-bill from the French Data Library.
Source: Morningstar, French Data Library.

Liquidity Challenges

Senior loans sound like a good deal. They have historically had lower credit losses than high-yield bonds,
less interest-rate risk than intermediate-term, fixedrate bonds, and higher yields than many other shortduration instruments. But it is important to bear in
mind that these high yields are compensation for risk.
In addition to their credit risk, these loans carry
considerable liquidity risk.
Senior loan originators can sell their portion of the
loan to other investors on the secondary market.
Unlike traditional bonds, these loans do not settle on
a T+3 schedule (three days after the transaction
date). In fact, there is no maximum settlement period
for these loans, though the median settlement
period in the first three quarters of 2015 was 12 days
according to the LSTA. That can pose a challenge
to funds that provide daily liquidity such as mutual
funds and exchange-traded funds.
Funds generally have four options to manage this
liquidity risk:
1 | Hold a portion of their portfolios in cash, high-yield
bonds, or other securities with T+3 settlement.
This is one of the strongest lines of defense. Cash and
liquid securities offer a buffer to help senior loan
funds meet redemptions, but these holdings dilute
exposure to senior loans.
2 | Stick to the most liquid senior loans.
Settlement times for these loans tend to be shorter.

March 2016

3 | Request accelerated loan settlement.

Counterparties are not required to offer accelerated
settlement, though many of these funds managers indicate that their counterparts are usually
willing to accommodate their requests for accelerated settlement.
4 | Establish an emergency line of credit.
If all else fails, a line of credit can give a fund the
cash it needs to meet investors daily liquidity
needs while it is waiting for the sale of its underlying
loans to settle.

Together, these lines of defense should enable

managers to provide daily liquidity, even in periods of
market stress, but they dont entirely eliminate
liquidity risk. Senior loans are generally less heavily
traded than bonds. If a manager wants to sell a
loan, it may take longer to find a buyer and he may
have to accept a lower price to make the transaction
happen. Therefore, it can be expensive to demand
liquidity in this market.
Senior Loan ETFs

In light of the liquidity challenges senior loans face, an

ETF wrapper may not seem like a suitable vehicle for
investing in them. In fact, BlackRock has cited liquidity
challenges as a key reason not to launch a senior
loan ETF. Despite these challenges, four senior loan
ETF s exist: PowerShares Senior Loan ETF BKLN
(0.65% expense ratio), SPDR Blackstone/GSO Senior
Loan ETF SRLN (0.70% expense ratio), First Trust
Senior Loan ETF FTSL (0.85% expense ratio), and
Highland/iBoxx Senior Loan ETF SNLN (0.55%
expense ratio). Liquidity risk management is a priority
for these ETF managers. Each employs all four of the
liquidity management techniques previously described
and uses cash creations and redemptions, which
makes it easier for authorized participants to provide
liquidity. BKLN and SNLN are index strategies, while
SRLN and FTSL are actively managed.
Indexing illiquid assets can result in high transaction
costs, as index changes create liquidity-demanding
trades that can push loan prices away from index fund

managers. In order to mitigate this potential problem,

BKLN (by far the biggest senior loan ETF ) tracks the
S&P/LSTA U.S. Leveraged Loan 100 Index, which
targets the 100 largest senior loans and weights them
by market value. These are among the markets most
liquid senior loans. While the indexs design improves
the funds overall liquidity profile, it could also
skew the portfolio toward the most heavily indebted
borrowers. Invesco (PowerShares parent company)
subadvises the fund. The management team, led by
Scott Baskind, is willing to accept some tracking
error to manage liquidity risk. They generally keep
8% 9% of the portfolio in cash and 7% 9% in
high-yield bonds with T+3 settlement. Where possible,
it targets the bonds of issuers in the index.
SNLNs index directly screens for the 100 most liquid
senior loans, which it weights by market value. But
it tends to have considerable overlap with BKLN. As of
Jan. 27, 2016, their common holdings accounted for
64% of SNLNs portfolio. Unlike BKLN, SNLN does not
hold any high-yield bonds. It does, however, currently
have a 7% cash stake, according to Morningstar data.

Active management is probably a better way to go

in the bank-loan asset class, as it may allow for better
liquidity and credit risk management. And the cost
difference between the index and active strategies
is fairly small. SRLN and FTSL both have capable
management teams, but I prefer SRLN because of its
lower fee and GSOs leading position in the senior
loan market.
Blackstone/GSO subadvises SRLN. GSO is one of the
largest senior loan asset managers in the world.
Dan McMullen is the lead manager on the strategy,
and he is supported by a team of 19 credit analysts.
They attempt to identify mispriced loans through
bottom-up credit analysis, trying to catch things that
the ratings agencies miss. The managers may layer
on some top-down positioning to manage risk. Unlike
their ETF peers, they are able to take advantage
of opportunities in the primary market, which may
improve their odds of finding undervalued loans.

Qualifying loans must have at least $250 million

outstanding, which helps improve liquidity. The
managers generally keep around 2% of the portfolio
in cash (that figure is currently around 10% according to State Street) and 8% 10% in high-yield bonds
to further manage the funds liquidity needs.
The managers of FTSL also attempt to outperform
through fundamental credit analysis. Lead manager
Bill Housey and his team of analysts look for issuers
with stable cash flow, strong management teams,
and quality assets (as do many of their peers). They
share GSOs view that the ratings agencies are
slow to pick up on new information, which can create
mispricing that the managers can exploit. This team
screens loans for liquidity and makes lots of small bets
to reduce liquidity needs from any individual holding.
Cash and high-yield bonds typically account for
around 20% of the portfolio. K
Contact Alex Bryan at alex.bryan@morningstar.com